1. 1) A manufacturing company is considering replacing a broken metal cutting ma

Question

1.       1)A manufacturing company is considering replacing a broken metal cutting machine.  Several options have been proposed:

a.       Option 1: The broken machine can be sold today for $2,500.

b.      Option 2: It can be overhauled completely for $8,000, after which it will produce $3,000 in annual cash flows over the next five years.  The resale value of the asset at the end of five years is zero.

c.       Option 3: It can be replaced for $20,000.  The life of the replacement machine is five years, and it has an estimated salvage value of $3,000 at the end of five years.  The anticipated operating cash flows for each year will be $6,000.

If the firm

Explanation / Answer

Hi,

Please find the answer as follows:

You need to calculate the Net Present Value in each case to make the decision.

Option 1:

Present Value = 2500 (since it can be sold today for 2500)

Option 2:

NPV = -8000 + 3000/(1+.15)^1 + 3000/(1+.15)^2 + 3000/(1+.15)^3 + 3000/(1+.15)^4 + 3000/(1+.15)^5 = 2056.47

Option 3:

NPV = -20000 + 6000/(1+.15)^1 + 6000/(1+.15)^2 + 6000/(1+.15)^3 + 6000/(1+.15)^4 + 6000/(1+.15)^5 + 3000/(1+.15)^5 = 1604.46

Decision: Option 1 is the best option as it offers the maxium NPV. Company should sell the machine today itself.

Thanks.

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